Expected Credit Loss (ECL) is a key concept introduced by IFRS 9 Financial Instruments for measuring and recognizing credit losses on financial assets. Unlike the incurred loss model used in IAS 39, which recognized credit losses only when there was evidence of impairment, the ECL model is more forward-looking and aims to recognize credit losses earlier. ECL represents the weighted average of credit losses, with the weights being the probabilities of different default scenarios. It is essentially an estimate of the present value of cash shortfalls that a company expects to incur if a borrower defaults on their obligation. The shift to an ECL model under IFRS 9 helps financial institutions and other entities provide a more realistic picture of potential credit risk and ensures timely recognition of losses.
Components of ECL:
Probability of Default (PD): The likelihood that a borrower will default on their obligations.
Loss Given Default (LGD): The amount of loss a lender expects to incur if a default occurs, expressed as a percentage of the exposure at default.
Exposure at Default (EAD): The total value that is exposed to risk at the time of default.
Forward-Looking Information: IFRS 9 requires the inclusion of forward-looking macroeconomic data in the calculation of ECL, making it more reflective of current and expected future economic conditions.
Three Stages of credit risk under IFRS 9
Under IFRS 9, the three stages of credit risk refer to the classification of financial assets based on their credit risk level and the measurement of Expected Credit Loss (ECL). These stages help determine how and when credit losses are recognized. Here's an overview of each stage:
- Risk Identification and Assessment
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Stage 1: Performing Assets:
All financial assets start in Stage 1 upon initial recognition, provided there is no significant increase in credit risk.
- Measurement: ECL is calculated based on the 12-month ECL, which considers the probability of default over the next 12 months.
- Interest Calculation: Interest is calculated on the gross carrying amount (i.e., without deducting ECL allowances).
- Triggers: An asset remains in Stage 1 if the credit risk has not significantly increased since initial recognition.
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Stage 2: Underperforming Assets:
If there is evidence that the credit risk has significantly increased since the asset was initially recognized, it moves to Stage 2.
- Measurement: The ECL is calculated based on the lifetime ECL, which considers the probability of default over the asset's entire remaining life.
- Interest Calculation: Like Stage 1, interest is still calculated on the gross carrying amount.
- Triggers: Signs of increased credit risk could include deterioration in the borrower's credit rating, adverse economic conditions, or other indicators of financial distress.
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Stage 3: Credit-Impaired Assets:
When a financial asset shows objective evidence of impairment (e.g., past due payments, bankruptcy, or significant financial difficulties of the borrower), it moves to Stage 3.
- Measurement: ECL continues to be based on the lifetime ECL.
- Interest Calculation: In Stage 3, interest is calculated on the net carrying amount of the asset (i.e., after deducting the ECL allowance).
- Triggers: Indications of credit impairment can include the actual occurrence of default events or a substantial and prolonged deterioration in financial health.